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Bondholders May Be Forced to Pay for Cities' Bankruptcy Litigation

Alabama ruling could apply to any municipal bankruptcy with debt being paid by pledged revenues such as parking fees or water and sewer charges.

Detroit bondholders may have a new worry after a judge ruled that Jefferson County, Alabama, could have paid legal bills for its bankruptcy from cash that was going to pay warrant holders owed $3 billion.

The ruling should concern bond investors whose revenue was previously protected from use by municipalities, said R. Dale Ginter, a bankruptcy lawyer at Downey Brand LLP in Sacramento, California. It may force those bondholders to reconsider waging an extensive legal fight to protect their interests, said Ginter, who represented retirees in the bankruptcy of Vallejo, California.

“It puts a lot of leverage in favor of the debtor,” Ginter said. “It puts bondholders in the position of paying for both sides of their litigation.”

The ruling could apply to any municipal bankruptcy with debt being paid by pledged revenues such as parking fees, airport lease payments or water and sewer charges, Ginter said. Detroit is in talks to get bondholders and current and former city workers to accept $2 billion in exchange for wiping out the $11.5 billion they may be owed. Kevyn Orr, Detroit’s emergency financial manager, said he may put the city into bankruptcy if they can’t strike a deal.

Detroit has about $5.4 billion worth of water and sewer bonds that Orr has said would be paid in full under the city’s reorganization proposal. Orr, 55, is aware of the Alabama ruling and has no plans to dip into water and sewer funds to pay legal fees, Bill Nowling, his spokesman, said in an e-mail last week.

Orr already has rung up a $1.4 million tab for the first six weeks of work by the city’s attorneys, Nowling said. Should Detroit file for bankruptcy, the city’s legal fees may reach $10 million to $30 million a year, depending on the amount of litigation, Doug Bernstein, a bankruptcy lawyer with Plunkett Cooney in Bloomfield Hills, Michigan, said in an interview.

Cities and counties that file for bankruptcy under Chapter 9 of the U.S. Bankruptcy Code have more legal protections than companies that file under Chapter 11. Chapter 9 creditors can’t offer their own reorganization plan and aren’t entitled to form an official committee whose legal fees are paid by the bankrupt city or county.

Jefferson County filed the largest U.S. municipal bankruptcy in November 2011 partly to force warrant holders to accept a cut in sewer-system debt that county officials said the system couldn’t afford to pay. U.S. Bankruptcy Judge Thomas Bennett in Birmingham, Alabama, said last month that some of the sewer revenue could have gone to county bankruptcy lawyers.

‘A Change’

“This is a change from what people were assuming,” said Matt Fabian, managing director of Concord, Massachusetts-based Municipal Market Advisors. “It absolutely affects Detroit.”

Jefferson County may not be able to take advantage of the ruling because it has agreed that accumulated sewer revenue would be distributed to creditors without deducting the kinds of expenses Bennett said he would allow.

By January 2012, two months after its bankruptcy filing, the county had spent about $22 million on legal fees related to the restructuring of the sewer debt. To date, it has paid about $1 million a month in legal and other court-related bills, County Commissioner David Carrington said in an e-mail.

Carrington’s figure doesn’t include millions of dollars in fees related to the sewer debt that the county paid before the bankruptcy.

Last week, the trustee for Jefferson County’s warrant holders, two insurance companies that guaranteed repayment of the debt and warrant holder JPMorgan Chase Bank NA filed a notice in U.S. Bankruptcy Court in Birmingham saying they planned to appeal Bennett’s fee ruling.

Bennett issued the ruling a year after handing down a related opinion that some interpreted to say just the opposite. Municipal bond investors at the time assumed the judge had barred the city from spending sewer revenue on legal fees or in any way not authorized by the original debt contract, said Municipal Market Advisors’ Fabian.

Bennett said the earlier decision had been misinterpreted. The previous opinion addressed whether the county could set aside sewer money by estimating legal fees that may be incurred in the future without proper justification, he wrote.

Two insolvent cities, Harrisburg, Pennsylvania, and Stockton, California, may have debt that could qualify under Bennett’s ruling, Ginter said.

Stockton Debt

Harrisburg’s 2011 Chapter 9 filing was thrown out of court after a judge ruled the city council didn’t have authority to declare bankruptcy. Stockton, with debt that includes dedicated revenue from a parking garage, is negotiating with creditors on a plan to reduce debt and exit bankruptcy.

“It’s potentially pretty big,” Ginter said of the ruling.

Jefferson County supplanted Orange County, California, as the largest U.S. municipal bankruptcy. Orange County entered court protection in 1994 after losing $1.7 billion on interest-rate bets.

While Orange County’s petition initially listed more debt than Jefferson’s, much of that liability was reduced in the early weeks of the case. Thanks partly to lawsuits against financial firms, Orange County creditors were paid in full.

Detroit’s would be the biggest Chapter 9 case ever.

The case is In re Jefferson County, 11-bk-05736, U.S. Bankruptcy Court, Northern District of Alabama (Birmingham).

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